INVESTMENTS | BODIE, KANE, MARCUS Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. International Diversification

25-2 INVESTMENTS | BODIE, KANE, MARCUS Background By 2011, 52 countries have stock markets with a mkt. cap over $1 billion. U.S. accounts for <40% Developed countries account for 85% Total mkt. cap of corporate equity in 2011 was $38.2 trillion (U.S. = 36.4%). Top six countries make up 64% of the world portfolio. But is this diversified enough?

25-3 INVESTMENTS | BODIE, KANE, MARCUS Table 25.1, Market Capitalization of Stock Exchanges in Developed Countries

25-4 INVESTMENTS | BODIE, KANE, MARCUS Table 25.2, Market Capitalization of Stock Exchanges in Emerging Markets

25-5 INVESTMENTS | BODIE, KANE, MARCUS Background Clearly, U.S. stocks do not comprise a fully diversified equity portfolio. International investing provides greater diversification opportunities. It also carries some special risks.

25-6 INVESTMENTS | BODIE, KANE, MARCUS Issues A developed stock market enriches the population (Figure 25.1). However, certain issues still remain. Home-country bias: – Investors frequently overweight home-country stocks.

25-7 INVESTMENTS | BODIE, KANE, MARCUS Figure 25.1 Per Capita GDP and Market Capitalization as Percentage of GDP

25-8 INVESTMENTS | BODIE, KANE, MARCUS Risk Factors in International Investing Foreign Exchange Risk Variation in return due to changes in the exchange rate. Foreign investments may yield more or less home currency than expected. A foreign investment is simultaneously an investment in an overseas asset and in a foreign currency.

25-9 INVESTMENTS | BODIE, KANE, MARCUS Risk Factors in International Investing 1.Return expressed in local currency 2.Return obtained when local currency is exchanged for home currency. Two sources of variation or risk:

25-10 INVESTMENTS | BODIE, KANE, MARCUS Example 25.1 Exchange Rate Risk Suppose the risk-free rate in U.K. is 10% and the current exchange rate is $2/£1. A U.S. investor with $20,000 can buy £10,000 and invest them to obtain £11,000 in one year. If the £ depreciates to $1.80, the investment will yield only $19, 800, a $200 loss. The investment was not risk free to a U.S. investor!

25-11 INVESTMENTS | BODIE, KANE, MARCUS Example 25.1 Exchange Rate Risk The equation shows that the return to the U.S. investor is: – The pound-denominated return – Multiplied by – The exchange rate “return”

25-12 INVESTMENTS | BODIE, KANE, MARCUS Figure 25.2 Stock Market Returns in U.S. Dollars and Local Currencies for 2010

25-13 INVESTMENTS | BODIE, KANE, MARCUS Hedging Exchange Rate Risk Futures or forward markets are used to hedge the risk. The U.S. investor can make a riskless dollar return either by investing in UK bills and hedging exchange rate risk or by investing in riskless U.S. assets.

25-14 INVESTMENTS | BODIE, KANE, MARCUS Political Risk In principle, security analysis at the macroeconomic, industry, and firm-specific level is similar in all countries. In practice, getting good information about foreign investments can be more difficult. PRS Group (Political Risk Services) assesses political risk by country.

25-15 INVESTMENTS | BODIE, KANE, MARCUS Table 25.5 Variables used in PRS’s Political Risk Score

25-16 INVESTMENTS | BODIE, KANE, MARCUS Table 25.6 Current Risk Ratings and Composite Risk Forecasts

25-17 INVESTMENTS | BODIE, KANE, MARCUS Table 25.7 Composite and Political Risk Forecasts

25-18 INVESTMENTS | BODIE, KANE, MARCUS Table 25.7 Interpretation The table captures country risk through scenario analysis. Risk stability is based on the difference in the rating between the best- and worst-case scenarios.

25-19 INVESTMENTS | BODIE, KANE, MARCUS Table 25.8 Political Risk Points by Component

25-20 INVESTMENTS | BODIE, KANE, MARCUS Foreign Investment Avenues Purchase securities directly in the capital markets of other countries. American depository receipts (ADR) International mutual funds International ETFs

25-21 INVESTMENTS | BODIE, KANE, MARCUS Risk and Return: Summary Statistics Analysis focuses on excess returns over the risk-free rate, but differs across countries. Aggregated country-index portfolios, via value-weighted portfolios of developed and emerging markets based on mkt. cap.

25-22 INVESTMENTS | BODIE, KANE, MARCUS Risk and Return: Summary Statistics

25-23 INVESTMENTS | BODIE, KANE, MARCUS Are Investments in Emerging Markets Riskier? For the overall portfolio, standard deviation of excess returns is the appropriate measure of risk. For an asset to be added to the current portfolio, beta (covariance with U.S. portfolio) is the appropriate measure of risk.

25-24 INVESTMENTS | BODIE, KANE, MARCUS Figure 25.3 Monthly Std Deviation of Excess Returns in Developed, Emerging Markets

25-25 INVESTMENTS | BODIE, KANE, MARCUS Figure 25.4 Index Dollar Return Beta on U.S. Stocks, 2002–2011

25-26 INVESTMENTS | BODIE, KANE, MARCUS Figure 25.5 Average Dollar-Denominated Excess Returns

25-27 INVESTMENTS | BODIE, KANE, MARCUS Average Country-Index Returns and Capital Asset Pricing Theory Figure 25.5 shows a clear advantage to investing in emerging markets. Results are consistent with risk ranking by standard deviation, but not with ranking by beta. Beta rankings may fail because of home- country bias, which dominates international investing.

25-28 INVESTMENTS | BODIE, KANE, MARCUS Benefits from International Diversification

25-29 INVESTMENTS | BODIE, KANE, MARCUS Figure International Diversification

25-30 INVESTMENTS | BODIE, KANE, MARCUS Figure Efficient Frontier of Country Portfolios

25-31 INVESTMENTS | BODIE, KANE, MARCUS Are Benefits Preserved in Bear Markets? Correlations between countries may increase in a crisis. Roll’s model suggests a common factor underlying the movement of stocks around the world. Prediction: Diversification only protects against country-specific events. What happened in 1987? In 2008?

25-32 INVESTMENTS | BODIE, KANE, MARCUS Figure Regional Indexes around the Crash, October 14–October 26, 1987

25-33 INVESTMENTS | BODIE, KANE, MARCUS Figure Beta and SD of Portfolios

25-34 INVESTMENTS | BODIE, KANE, MARCUS Three Rules of Thumb To passively diversify your portfolio, include country indexes in order of: 1.Market capitalization (from high to low) 2.Beta against the U.S. (from low to high) 3.Country index standard deviation (from high to low)

25-35 INVESTMENTS | BODIE, KANE, MARCUS Figure Risks and rewards of international portfolios, 2000–2009

25-36 INVESTMENTS | BODIE, KANE, MARCUS Performance Attribution The EAFE index is a commonly used benchmark for portfolio performance. Measure the contribution of: 1.Currency selection 2.Country selection 3.Stock selection 4.Cash/bond selection

25-37 INVESTMENTS | BODIE, KANE, MARCUS Table Example of Performance Attribution: International